Moral hazard in banking is a situation where financial institutions take on excessive risk because they are protected from bearing the full consequences of their actions.
This problem arises primarily from two sources:
The 'Too Big to Fail' concept: Some large financial institutions are considered so important to the economy that the government won't allow them to fail. This belief encourages reckless risk-taking.
Deposit insurance: While deposit insurance protects depositors' money, it can also reduce depositors' incentive to monitor their bank's behavior, and embolden banks to pursue risky activities.
Moral hazard can lead banks to take unnecessary risks, threatening financial stability. The 2008 financial crisis is a prime example of moral hazard in action, where banks took massive risks knowing they'd likely be bailed out.